Monday, January 14, 2013

Peter Howitt... beyond equilibrium

Mostly on this blog I've been arguing that current economic theory suffers from an obsession with equilibrium concepts, especially in macroeconomics, or in models of financial markets. Most of the physical and natural world is out of equilibrium, driven by forces that are out of balance. Things never happen -- in the oceans or atmosphere, in ecosystems, in the Earth's crust, in the human body -- because of equilibrium balance. Change always comes because of disequilibrium imbalance. If you want to understand the dynamics of almost anything, you need to think outside of equilibrium.

This is actually an obvious point, and in science outside of economics people generally don't even talk about disequilibrium, but about dynamics; it's the same thing. Equilibrium means no dynamics, rest, stasis. It can't teach you about how things change. But we do care very much about how things change in finance and economics, and so we need models exploring economic systems out of equilibrium. Which means models beyond current economics.

The need for disequilibrium economics was actually well accepted back in the 1930s and 40s by economists such as Irving Fisher in the US and Nicholas Kaldor in England. Then in the 1950s, with the Arrow-Debreu results, and later with the whole Rational Expectations hysteria, it seems to have been forgotten. It's curious I think that really good economists, clear thinking people who are trying to address real world issues, often have no choice but to try to understand episodes of dramatic change (bank runs, bubbles, liquidity crises, leverage cycles) by torturing equilibrium models into some form that reflects these things. The famous Diamond-Dybvig model of bank runs is a good example. The model is one with multiple equilibria, one of which is a bank run. This is indeed insightful and useful, essentially showing that some sharp break can occur in the behaviour of the system, and also offering some suggestions about how runs might be avoided with certain kinds of banking contracts. But isn't it at least a little strange to think of a bank run, a dynamic event driven by amplification and contagion of behaviour, as an "equilibrium"?

I'm not alone in thinking that it is a little strange. Indeed, by way of this excellent collection of papers maintained by Leigh Testfatsion, I recently came across an excellent short essay by economist Peter Howitt which makes arguments along similar lines, but in the area of macroeconomics. The whole essay is worth reading, much of it describing in practical terms how, in his view, central banks have in recent decades moved well ahead of macroeconomic theorists in learning how to manage economies, often using tactics with no formal backing in macroeconomic theory. Theory is struggling to keep up, which is probably not surprising. Toward the end, Howitt makes more explicit arguments about the need for disequilibrium in macroeconomics:

The most important task of monetary policy is surely to help avert the worst outcomes of macroeconomic instability – prolonged depression, financial panics and high inflations. And it is here that central banks are most in need of help from modern macroeconomic theory. Central bankers need to understand what are the limits to stability of a modern market economy, under what circumstances is the economy likely to spin out of control without active intervention on the part of the central bank, and what kinds of policies are most useful for restoring macroeconomic stability when financial markets are in disarray.

But it is also here that modern macroeconomic theory has the least to offer. To understand how and when a system might spin out of control we would need first to understand the mechanisms that normally keep it under control. Through what processes does a large complex market economy usually manage to coordinate the activities of millions of independent transactors, none of whom has more than a glimmering of how the overall system works, to such a degree that all but 5% or 6% of them find gainful unemployment, even though this typically requires that the services each transactor performs be compatible with the plans of thousands of others, and even though the system is constantly being disrupted by new technologies and new social arrangements? These are the sorts of questions that one needs to address to offer useful advice to policy makers dealing with systemic instability, because you cannot know what has gone wrong with a system if you do not know how it is supposed to work when things are going well.

Modern macroeconomic theory has turned its back on these questions by embracing the hypothesis of rational expectations. It must be emphasized that rational expectations is not a property of individuals; it is a property of the system as a whole. A rational expectations equilibrium is a fixed point in which the outcomes that people are predicting coincide (in a distributional sense) with the outcomes that are being generated by the system when they are making these predictions. Even blind faith in individual rationality does not guarantee that the system as a whole will find this fixed point, and such faith certainly does not help us to understand what happens when the point is not found. We need to understand something about the systemic mechanisms that help to direct the economy towards a coordinated state and that under normal circumstances help to keep it in the neighborhood of such a state.

Of course the macroeconomic learning literature of Sargent (1999), Evans and Honkapohja (2001) and others goes a long way towards understanding disequilibrium dynamics. But understanding how the system works goes well beyond this. For in order to achieve the kind of coordinated state that general equilibrium analysis presumes, someone has to find the right prices for the myriad of goods and services in the economy, and somehow buyers and sellers have to be matched in all these markets. More generally someone has to create, maintain and operate markets, holding buffer stocks of goods and money to accommodate other transactors’ wishes when supply and demand are not in balance, providing credit to deficit units with good investment prospects, especially those who are maintaining the markets that others depend on for their daily existence, and performing all the other tasks that are needed in order for the machinery of a modern economic system to function.

Needless to say, the functioning of markets is not the subject of modern macroeconomics, which instead focuses on the interaction between a small number of aggregate variables under the assumption that all markets clear somehow, that matching buyers and sellers is never a problem, that markets never disappear because of the failure of the firms that were maintaining them, and (until the recent reaction to the financial crisis) that intertemporal budget constraints are enforced costlessly. By focusing on equilibrium allocations, whether under rational or some other form of expectations, DSGE models ignore the possibility that the economy can somehow spin out of control. In particular, they ignore the unstable dynamics of leverage and deleverage that have devastated so many economies in recent years.

In short, as several commentators have recognized, modern macroeconomics involves a new ‘‘neoclassical synthesis,’’ based on what Clower and I (1998) once called the ‘‘classical stability hypothesis.’’ It is a faith-based system in which a mysterious unspecified and unquestioned mechanism guides the economy without fail to an equilibrium at all points in time no matter what happens. Is there any wonder that such a system is incapable of guiding policy when the actual mechanisms of the economy cease to function properly as credit markets did in 2007 and 2008?

Right on, in my opinion, although I think Peter is perhaps being rather too kind to the macroeconomic learning work, which it seems to me takes a rather narrow and overly restricted perspective on learning, as I've mentioned before. At least it is a small step in the right direction. We need bigger steps, and more people taking them. And perhaps a radical and abrupt defunding of traditional macroeconomic research (theory, not data, of course, and certainly not history) right across the board. The response of most economists to critiques of this kind is to say, well, ok, we can tweak our rational expectations equilibrium models to include some of this stuff. But this isn't nearly enough.

Peter's essay finishes with an argument as to why computational agent based models offer a much more flexible way to explore economic coordination mechanisms in macroeconomics on a far more extensive basis. I cannot see how this approach won't be a huge part of the future of macroeconomics, once the brainwashing of rational expectations and equilibrium finally loses its effect.